States at crossroads as VAT date nears, 30% revenue at stake

It’s almost certain now that the country will keep its date with value-added tax (VAT). Going by the present pace, Indian states will be VAT-ready before the April 1, ’05 deadline. Incidentally, Haryana has already implemented it.

This will be the most important tax reform in independent India said finance minister P. Chidambaram after releasing the “White Paper� on VAT.

Nobody will disagree with Mr Chidambaram and will not doubt the significance of VAT. VAT has proved extremely beneficial to consumers, taxpayers and governments across the world.

While consumers will get price advantage as they will have to pay lower tax for the product under VAT, the incentives to pay tax will boost compliance rate inflating the government’s tax kitty.

The best example is that of Haryana whose revenues reportedly, has shot up by 30% in about a year after it implemented VAT.

More significantly, VAT will remove the cascading effects of charging excise duties and sales tax on inputs at every stage of the production cycle.

Tax will now be imposed only on the value added at each level of production. That is, the tax will now be on income.

According to Swaminathan S Anklesaria Aiyar: “VAT is an alchemist converting indirect taxes into direct taxes. It obliges us to confront a basic economic truth: The value of a product is simply the total of incomes of participants in its production. So, a foolproof VAT will capture all income. Even those who seek to evade VAT will not really succeed. A manufacturer who refuses to declare his production will pay no VAT on his output and no income tax either. But he has already paid VAT on his purchased inputs, and will not be able to claim a refund. Willy nilly, he is in the tax net.�

As the blueprint stands, two basic VAT rates of 4% and 12.5% for 530 items are expected to be in place after April 1, 2005, with a list of specific category of tax-exempted goods.

A special VAT rate of 1% will also be implemented for gold and silver ornaments. Few goods outside VAT will continue to be taxed under the Sales Tax Act.

A pilot project of the IT system—National Tax Information Exchange System—has already taken off in some states last year.

Once this system is extended to all states, this will integrate all state tax transactions under one roof and provide digital access to all inter-state transactions.

The system will not only make the exercise transparent but is expected to plug tax evasion also.

Of course, Indian states were aware of all these but were opposing it for a different reason. They were apprehensive of the implementation part and feared revenue loss.

Now that the central government has agreed to compensate the state governments if there is any loss due to transition to VAT, states feel safe.

In the first year, the state governments will get 100% compensation, in the second year this will be 75% and in the third year 50%. This is significant.

More than the prospect of higher revenue earnings in future, New Delhi’s assurance to compensate for any shortfall in revenue in the transition period must have prompted the states to agree to this change.

After all, the stake is enormous for them. Sales tax is about the only important avenue under their jurisdiction to raise revenue.

An ET survey of 29 Indian states found that about a third of their aggregate revenue is estimated to come from sales tax alone in ’04-05 (Budget estimates). And this has been the story all along.

In each of the last six years about 30% of states’ total revenue earnings were accounted for by sales tax. As such, most of these states are running huge fiscal deficits and any shortfall in sales tax earnings would leave them bankrupt.

The stake is even higher for states such as Kerala, Tamil Nadu, Maharashtra, Gujarat and Andhra Pradesh whose dependence on sales tax is higher than that of the states in general. Half of Kerala’s revenue earnings in 2004-05 is to come from sales tax alone.

About 47.3% of Maharashtra and 42.1% of Tamil Nadu’s aggregate budgetary revenue earnings during the same period is estimated to come from sales tax collections.

Aggregate sales tax collections of the states is estimated to increase by 14% in ’04-05 over the previous year.

Of course, with the rise in the magnitude of dependence sales tax collections has increased steadily over the years—up by 80% during the last five years, between 1999-00 and ’04-05(BE) or by an annual compound rate of 12.5%.

At the individual level many of these states have more than doubled their collections during this period. Among the major states Haryana has increased its sales tax collections by 116%, Himachal Pradesh by 113.4% and Punjab by 103.6% between 1999-00 and ’04-05.

Sales tax collections in Maharashtra, Madhya Pradesh, Tamil Nadu and Gujarat at the other end, have grown at a lower rate compared to the national average during this period.

The importance of sales tax in state’s budgetary exercise will probably be best understood when compared with state’s own revenue earning figures. More than 60% of states’ total tax revenue comes from sales tax alone.

State finance ministers often talk of innovative revenue earning measures during the Budget time but fall back to sales tax for serious business and fine tune it further to match their Budget arithmetic.

Now that VAT will replace sales tax one wonders how will the state finance ministers make their estimates. After all, this was about the only area they had at their disposal to tinker with effectively.